Bank of America's autocallables linked to Russell have many moving parts but attractive upside

By Emma Trincal

New York, July 29 - Bank of America Corp.'s 0% autocallable market-linked step-up notes due August 2016 linked to the Russell 2000 index are attractive for bulls as long as investors are comfortable with a hybrid structure featuring different payout scenarios based on different durations, sources said.

The notes will be called at par of $10 plus a premium if the index's closing level is greater than or equal to the initial level on either observation date. The premium will be 9% if the notes are called in September 2014 or 18% if the notes are called in August 2015.

If the notes are not called and the final index level is greater than or equal to the initial index level, the payout at maturity will be par plus the greater of the step-up payment and the index return. The step-up payment is expected to be 20% to 26% and will be set at pricing. Investors will receive par if the index declines by 5% or less and will lose 1% for every 1% that it declines beyond 5%, if any.

Enhanced return

"I like that note," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"The call condition is very easy to meet: All you need is the index to be flat on the call date and you can get 9% after one year.

"I'm getting a specified return. I suspect this is a one-year. I don't think it's going to be a three-year. I don't think you have to worry about holding this note to maturity."

Kunhardt based his assumption on the benchmark's historical performance.

"The Russell usually runs in three- to five-year cycles. It's very rare to get three years of losses. Such scenario is not very likely. I can't think of any time when the Russell was down three years straight," he said.

Even in the absence of a call, investors can still participate in the upside, which made the note unique compared to traditional autocallables, he said.

"I would be using it as enhanced return. You're not taking any greater risk than if you were long the Russell 2000 index," he noted.

Kunhardt said that he uses structured notes for various purposes: as a hedge, as an alternative investment, for enhanced growth and as a fixed-income replacement.

Three bites

"I wouldn't use it for hedging," he said.

"I wouldn't put it as alternative investment either. Since I'm indexing, I'm not doing it to get a different correlation.

"It's not fixed-income replacement either. There is no fixed income. The duration itself may vary.

"This one would fit in my enhanced growth allocation. At maturity, I'm fully participating in the index, and I'm not taking any more risk than being long the index."

Kunhardt said that the notes would fit various bullish views depending on whether one anticipates the call on one of the call dates or the participation at maturity.

"With the two call dates plus the maturity payout, you get three chances to bite the apple," he said.

"If you get called and the index is up by more than the premium, then you're not getting any of the upside above 9%. That's your upside risk. You can't be too greedy, and in this case, you're capped. But I would say 9% per year is nothing to be sorry about.

"If you're still holding the notes at maturity, in that case it's a pure growth play with no maximum return. This is pretty different from most autocallables. You're not penalized by a cap at maturity."

Kunhardt said that he was not concerned with the thin downside protection.

"If the Russell 2000 ends up negative at maturity, it means small caps are losing money. The 5% buffer is not much, but I don't really care because I'm buying exactly for what they built it - enhanced return - and not as a defensive play," he said.

"Besides, if the [Russell] 2000 is losing money after three years, pretty much nothing else is making money on the equity side, so you would've lost money anyway.

"To me this is a pure performance play."

Moving parts

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that the complexity of the payout made the product difficult to assess unless one had a very specific view on the index of moderate growth.

"This is not an uninteresting note. But before I can pull the trigger with a client, I would need to run the numbers on this and see what the possible outcomes may be," Kalscheur said.

"It's not easy because this structure has a lot of moving parts, which makes me hesitant to even consider it."

Investors face the uncertainty of a variable duration since they do not know in advance whether the notes will be called or not, he said. The payout could be fixed or equal to the index return based on different assumptions. For instance, the call premium and the step-up payments would represent fixed payouts while the uncapped participation would vary.

"All those different options depend on the level of the index at different dates," he said.

"You don't know what your payout is going to look like. You also don't know the duration of the notes. It could be three years or it could be one," he said.

The uncertainty and variability of the terms made the product difficult to allocate, in his view.

"The product is very intriguing. But it's one of these things where you've got to be careful on how you allocate it. Where are you taking the money from? Is it for a capped equity allocation? Chances are you'll get called out in one of the two years. While a call is very likely, the odds for the call to occur are difficult to quantify because no one really knows what the market will be like on a specific day," he said.

"As a result, I can't price on the back of an envelope with 90% certainty that you will get called out in two years. This is a one-, two- and three-year product. It's not like measuring the probability of future returns on a simple point to point."

Positive features

Among the positive features was the 5% buffer. "At least that's something," he said.

The creditworthiness of Bank of America was also valuable, according to Kalscheur.

"It's a single-A- issuer. For us, it's fine. It's in the realm of investable credit," he said.

"The [2%] fee is a little bit more than what I would like to pay for on a three-year period, but it's definitely not a deal-breaker."

Finally the proposed returns were attractive as well.

"Most people would be happy with 9% after one year or 18% after two years. These are great returns," he said about the call premium rates.

"The step-up is also appealing. A 20% to 26% return is about 7.5% annualized. That's not bad, especially if the index is flat," he said.

Finally, the uncapped upside at maturity was also a positive aspect of the deal.

Close trading range

However, Kalscheur said that he would not be comfortable showing the notes to a client.

"Part of the problem is that I have a love/hate relationship with autocallables," he said.

"If you get called, things are going well but you've missed the upside. That's the risk with this note. So if the market is doing well, you're going to have to settle for a lower return. That's problem number one.

"Problem number two: it's definitely an equity allocation, but it's hard to see where it fits. Compare it with a three-year, plain vanilla note, which would have for instance a 20% buffer on the downside and no cap on the upside. If the market is way up, you're better off with the plain vanilla note because you won't get called. Same thing if the market is down since you have a competitive buffer. You're only doing better with this product in a middling type of market."

One of the weaknesses of the notes, he said, was that its payout was beneficial only to investors with a specific and narrow view of the market.

"This note fits a particular scenario: the market has to be up but not up very much. It can't be up double-digit. You're betting on the index trading in a fairly close trading range," he said.

"The Russell has been up 30% over the last two years. If you're confident that the market will take a breather and that we'll have growth but not 30% growth year over year, you may want to look at it.

"This is a note for someone who has a moderately bullish outlook on the index.

"If you are a hard-charging bull, this is not a product for you.

"I am a moderate bull. I'm not a pessimist. I'm certainly not a bear, so I guess I wouldn't disagree with the fundamental view.

"And yet, I wouldn't feel comfortable showing this note to a client. There are too many variables, too many moving parts. I'm not confident about the possible outcome.

"The product is very intriguing. I suspect it's a good structure. My hesitation is that I don't have the numbers and the statistics to verify and justify my gut instincts on this. So I can't really see the value of it."

BofA Merrill Lynch is the underwriter.

The notes will price in August and settle in September.

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